The most prominent case relates to the $70bn Blackstone Real Estate Income Trust (BREIT) which had to handle $4.5bn of redemptions in March, up from $3.9bn, despite having organised a meeting with 200 investors in early March to lure them in the investment vehicle arguing that the pullback by the US regional banks from the sector would offer attractive opportunities with better pricing terms.

In a macroprudential published in early April, the European Central Bank has reflected similar concerns as the Real Estate Investment Funds in the eurozone have become a significant player in the commercial real estate (CRE) market.

Reifs primarily invest directly in physical properties or indirectly through the financing of its debt or equities in real estate companies. The sector has seen its relevance increased over the last decade to become systematically important, as it now represents 40% of the CRE markets in the euro area, compared to 20% in 2013, according to the ECB. According to the Association of the Luxembourg Fund Industry, the majority of the CRE investments in Luxembourg are held in financial instruments in which the underlying assets are in other European countries.  

What goes up…

The CRE market is likely to be sensitive to adverse shocks given that prices have seen a strong growth in the years leading to the pandemic. A period of further adjustments appears likely, as ECB survey data shows that investors are observing a market downturn and worsening financing conditions, both reaching the worst levels since 2013, whereas more than 60% of the investors perceive prices to be expensive or very expensive.

The ECB has observed that “the tighter financing conditions and macro-financial uncertainty began to materialise, with a sharp drop in transaction numbers and falling prices”. Indeed, market activity fell by 44% in 4Q22 compared to 4Q21, “as buyers revise down their bid prices faster than sellers revise their asking prices”.

 The office and retail sectors have not fully recovered from the covid-19 pandemic and remain the most affected industries given the shift in preferences toward to working-from-home and e-commerce.

The health of the Reifs directly impacts the collateral values and the lending, and the wider financial system, as it competes directly with banks for loan financing. During market stresses, the ECB wrote, “it is difficult to accurately value and sell illiquid property assets which may increase the likelihood of investor runs,” an outcome that it is considering as more likely with open-ended funds.

Importantly, the ECB is concerned that Reifs offering frequent redemptions may be exposed to liquidity mismatches and present risk to financial stability. The ECB stated, “If appropriate liquidity management tools (LMTs) are not in place, REIFs could have to resort to asset fire sales, thus amplifying market stress”.

The free movement of capital, one of the four fundamental freedoms of the EU single market, is not only facilitating diversification for the Reif market, but may also be a source of concerns due to the interconnectedness in euro area CRE markets, as resulting price pressure and outflows in one country may trigger a similar outcome another country.

Risks related to leverage

Leverage is also binding Reifs and financial institutions together in multiple ways. The banks do not only compete to fund real estate projects, but they also fund Reifs. Moreover, a high level of leverage, a reduction of credit availability and a higher funding cost do not only magnify the vulnerabilities of the Reifs to downward pricing pressure, but their eventual financial difficulties may have an impact directly or indirectly on financial institutions and to the stability of the entire financial system.

Access to credit and higher (re)funding cost may also be only part of the headache. Promoters with assets in secondary real estate realise that additional cost may be required to adapt their real estate assets to modern environmental standards.  

Despite the claims by some market participants that leverage is lower in the market today, it remains to be seen whether these developments will escalate into a crisis and wreak havoc with the Europeans banks, as seen in 2008-09, or rather hit asset owners, the Reifs, among others, to a greater degree. However, the Reifs may still nastily harm the banks with second degree shocks despite the latter being more conservative than during the great financial crisis.

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .